Corporate bankruptcy presents a puzzle. Why does the law provide special rules that apply only in financial distress? One can imagine
—or advocate for—a world in which no such rules exist. But that is not the world we live in. Bankruptcy laws do exist in the United States and in most major legal systems throughout the world. And so to confront the puzzle, one must identify the purpose that bankruptcy law serves. This Article attempts to do just that and then shows how United States bankruptcy law pursues that purpose.
In short, corporate bankruptcy law’s proper purpose is to solve the incomplete contracting problem that accompanies financial distress. And Chapter 11 of the United States Bankruptcy Code implements that purpose—perhaps imperfectly—by facilitating a structured renegotiation that allows parties to preserve value in the face of hold-up threats.
This Article suggests that the creation of this bargaining framework for renegotiation is the fundamental attribute of Chapter 11.
Thus, contrary to the prevailing view, the purpose of bankruptcy law is not to vindicate or mimic some hypothetical ex ante bargain among creditors.
That idea—the Creditors’ Bargain Theory
—is, at best, a shorthand for the unexceptional claim that bankruptcy law should be efficient. In a hypothetical world of perfect information, zero transaction costs, and rational behavior, the interested parties (assuming one can define that category) would agree to efficient rules. But that is a truism that applies to almost any efficiency problem in law. All-knowing rational actors will always bargain to the efficient outcome when bargaining costs are zero.
But what should the law do when bargaining costs are high and information is limited? That is the bankruptcy question. Or, to be a little more precise, what should the law do when a particular set of relationships repeatedly presents the same problem of high bargaining costs and limited information? To that question, the hypothetical bargain is not responsive. It assumes perfect information and zero bargaining costs in a world where neither can ever be achieved. In a sense, the parties cannot write a complete contract because of uncertainty, and the Creditors’ Bargain Theory responds by instructing lawmakers—who face the same uncertainty—to write a complete contract for them.
Even worse, the Creditors’ Bargain framework often leads scholars to focus on the wrong questions. For example, by focusing attention on the initial bargain, the framework attracts reform proposals designed to bring all creditors to the ex ante bargaining table.
But the real problem for any bankruptcy contract—or legislation—is not in convening the bargainers. It is in dealing ex post with the incomplete terms those parties actually drafted. This is a classic problem in law,
and the Creditors’ Bargain Theory distracts from its importance.
The Creditors’ Bargain Theory has also nurtured the fallacy that bankruptcy law is primarily about preserving nonbankruptcy entitlements.
This idea—the Butner Principle
—is a corollary to the Creditors’ Bargain Theory and is often viewed as an additional source from which to derive bankruptcy’s core purpose.
But this gets things wrong. The bankruptcy system functions almost exclusively by doing the opposite of what the Butner Principle instructs—it achieves its purpose by directly interfering with nonbankruptcy entitlements.
This fallacy—that the Butner Principle is fundamental to bankruptcy theory—arises, perhaps, from a misunderstanding of bankruptcy’s efficiency goal. An efficient bankruptcy law should create more value than it destroys, accounting for consequences in and out of bankruptcy. That requires a balancing of effects across all states of the world, but it does not require any special protection for nonbankruptcy entitlements. In short, bankruptcy law should not be put into effect unless it creates net value.
All of this is to say, the law-and-economics theory of corporate bankruptcy needs to be restated. Though many scholars and lawyers invoke the Creditors’ Bargain Theory and the Butner Principle, very few rely on the truth of their substance. The building blocks of a new theory can be found in much of today’s bankruptcy scholarship, which usually advocates general efficiency goals,
often notes the importance of ex post bargaining,
and sometimes emphasizes the importance of procedure over substance.
Many scholars and lawyers also agree—at least implicitly—that corporate bankruptcy has something to do with facilitating ex post cooperation among stakeholders.
This Article does not depart from the current literature on these basic points. The challenge is in clearing away the distracting brush of old theories to discover a full and proper theory. Thus, this Article presents and justifies the New Bargaining Theory of corporate bankruptcy and demonstrates that Chapter 11’s renegotiation framework is consistent with a rough attempt to implement that theory.
This Article presents two claims, one normative and one descriptive. The normative claim is that bankruptcy’s proper purpose is to solve a specific contracting failure. That failure arises because financial distress presents uncertainty that is not contractible.
For a business firm, financial distress involves too many parties with strategic bargaining incentives and too many contingencies for the firm and its creditors to define a set of rules for every scenario. Moreover, the terms the parties do contract for will often be unenforceable because the relevant contingencies are impossible to verify to a court.
Incomplete contracts therefore govern a firm’s various relationships when distress arises.
The parties in those relationships can then take advantage of the incompleteness to extract individual gains from each other—to hold each other up. Any party who has specifically invested in its relationship with the debtor is vulnerable to this hold-up threat.
The problem cannot be solved by ex ante rules—in a contract or in a statute.
Indeed, the issue arises precisely because no one can write such rules. This is a familiar problem, but the law treats it differently in the bankruptcy context. And for good reason. The noncontractible uncertainty associated with financial distress is a recurring characteristic across all firms. Where every relationship of a certain type is incomplete and requires judicial intervention upon the occurrence of the same event, a uniform bankruptcy system that deals with those relationships will produce consistency, efficiency, and market predictability.
The descriptive claim of this Article is that Chapter 11 is an attempt—albeit an imprecise one—at such a system.
It creates a renegotiation framework designed to minimize the parties’ ability and incentives to hold each other up. The framework imposes judicial oversight and substantive outer limits on the parties’ decisions. It also allocates power over certain decisions to one party while subjecting the exercise or removal of that power to evidentiary burdens, pricing mechanisms, and other conditions targeted at proving the absence of hold-up behavior. The initial allocation of power and conditions is based on the perceived likelihood that the decision in question is subject to incomplete contracting and hold-up problems. In light of substantive uncertainty, the system relies mostly on procedural protections, giving judges wide discretion to define the bargaining parameters while leaving most substantive decisions to ex post bargaining among the parties. In a sense, the law puts in place guardrails that give the parties room to bargain while keeping them from taking positions that veer toward extreme hold up.
Bankruptcy law, then, is not about mimicking a hypothetical bargain. It is about facilitating an actual bargain. This is the New Bargaining Theory of corporate bankruptcy stated generally. Consistent with this theory, Chapter 11 implements a renegotiation framework to facilitate ex post bargaining.
This Article provides specifics on this theory and demonstrates that questions of cramdown, executory contracts, forum shopping, the automatic stay, third-party releases, intercreditor agreements, priority rules, and the like can all be understood and explained by a proper application of the New Bargaining Theory.
Two key features are worth highlighting now: First, ex post bargaining is front and center. That is where bankruptcy law happens. To be clear, the New Bargaining Theory does not reject the idea of ex ante efficiency. An efficient bankruptcy system is focused on solving the ex post problem if, but only if, it can do so without creating bigger problems in other states of the world. This focus presents a meaningful limitation on the implementation of any bankruptcy measure.
Second, Chapter 11’s renegotiation framework relies heavily on judicial discretion and procedural measures that facilitate the ex post bargain.
Substantive measures—including value redistribution and deviations from nonbankruptcy priority—do, however, come into play to facilitate the bargain by realigning incentives or minimizing distortions that might otherwise occur.
Notably, this Article does not claim that Chapter 11 operates perfectly—judicial error and misaligned incentives do exist. But the New Bargaining Theory coherently explains the major aspects of Chapter 11 and reveals the questions necessary to assess whether it achieves its purpose. For example, it provides insight into Chapter 11’s proper scope. Because the potential for hold up arises when parties have made investments specific to relationships that involve or link in some way to the going-concern value of the debtor,
Chapter 11 should focus exclusively on regulating ex post behavior that might take advantage of those relationship-specific investments.
This Article proceeds in four Parts. Part I explores the usefulness and shortcomings of the Creditors’ Bargain Theory, the Butner Principle, and other heuristics that have been used to describe the core purpose of bankruptcy law. Part II provides the foundation for the New Bargaining Theory of corporate bankruptcy. Part III describes Chapter 11’s renegotiation framework. Part IV demonstrates the usefulness of this emerging theory by applying it to current issues of debate in bankruptcy law.